Last week, the ECB announced that it will begin a new program of quantitative easing on March 15 – a delay that allows plenty of time for various rugs to be pulled out, if the experience of recent years is informative. Assuming that the program proceeds as announced, the ECB envisions bond purchases of 60 billion euros per month. Fully 92% of these purchases must be made by the central banks of individual countries in the Eurosystem, with the ECB sharing the risk of losses on only 20% of it (12% being investment-grade institutional debt, and 8% being the sovereign debt of Euro-area countries). This was essentially as expected, but –Â thus far –Â without an option for national central banks to treat their share of purchases as discretionary. I still suspect that this shoe will drop in the weeks ahead, but there's actually a much more important factor driving our outlook.
Is Q-ECB a favorable development? With regard to the stock market, our immediate response is to examine market internals, credit spreads, and other measures that provide information about the risk-preferences of investors. The difference between an overvalued market that continues to advance, and an overvalued market that drops like a rock, is primarily determined by those risk-preferences. For now, we observe no meaningful evidence that investor preferences have shifted back to risk-seeking.
Put simply, quantitative easing “works” to inflate the prices of risky securities only to the extent that low-interest, default-free liquidity is viewed as an inferior asset compared to risky securities. We’re not seeing evidence of that to an extent that defers our concerns about extreme overvaluation, overbought market action, overbullish sentiment, widening credit spreads, a flight-to-safety in Treasury yields and weakness in oil and industrial commodity prices that is consistent with an abrupt shortfall in global economic activity.
Investor preferences may change, which we’ll infer from market internals and measures sensitive to credit and risk tolerance. That sort of shift may significantly defer the immediacy of our concerns about market valuations, but it won’t make stocks any less hypervalued, and in any event, we don’t observe that kind of shift at present. Our outlook remains hard-negative for now.
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